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FTC v. ALLIANT TECHSYSTEMS INC.

November 23, 1992

FEDERAL TRADE COMMISSION, Plaintiff,
v.
ALLIANT TECHSYSTEMS INC., Defendant, and OLIN CORPORATION, Intervenor-Defendant.



The opinion of the court was delivered by: LOUIS F. OBERDORFER

 Plaintiff, the Federal Trade Commission ("FTC" or "Commission"), seeks a preliminary injunction pursuant to § 13(b) of the Federal Trade Commission Act, 15 U.S.C. § 53(b), to enjoin a pending merger between defendants, two defense contractors. Plaintiff alleges that the proposed merger, which will create a monopoly in the production of 120mm tank ammunition, violates § 7 of the Clayton Act, as amended, 15 U.S.C. § 18. Because plaintiff has demonstrated a likelihood that the merger will "substantially . . . lessen competition or . . . tend to create a monopoly," id., and because defendants have not demonstrated a threat to the national security that would override the public interest in promoting competition, plaintiff's motion for a preliminary injunction was granted on November 18, 1992, for reasons stated in an accompanying Memorandum and in a Supplemental Memorandum to be filed. This is that Supplemental Memorandum.

 I. FINDINGS OF FACT

 The Federal Trade Commission is an administrative agency of the United States organized and existing pursuant to the Federal Trade Commission Act, 15 U.S.C. § 41 et seq. ("FTC Act"). The Commission is responsible, inter alia, for enforcing federal antitrust laws, particularly § 7 of the Clayton Act, and §§ 5 and 13(b) of the FTC Act.

 Defendants are two private corporations which provide defense products by contract to the U.S. government. Defendant Alliant Techsystems Inc. ("Alliant"), designs, researches, develops, and manufactures various defense products, and renders related services, which it sells to the United States and foreign governments. Alliant is a pure defense company, with over 90 percent of its sales made to the United States Army ("the Army"). Defendant Olin Corporation ("Olin") manufactures chemicals and metals, and provides defense-related products and services.

 Both Olin and Alliant supply ammunition to the Army in large quantities. In particular, both serve as "systems prime contractors" supplying 120mm tank ammunition for M1A1 and M1A2 Abrams battle tanks. Systems prime contractors work with the Army to design and engineer a product to meet Army specifications, coordinate the production of various component parts by systems subcontractors in bulk quantities, and provide engineering, research and development, and quality assurance. The systems prime contractor is responsible for ensuring that the rounds ordered by the government are produced on schedule, on budget, and within specifications. The systems contractor owns the product and assumes the risk of failure until the Army certifies the product and title passes. See Olin Contract, Def. Ex. 108.

 120mm tank ammunition falls into two main categories: kinetic energy ("KE") rounds; and high explosive anti-tank ("HEAT") or chemical energy ("CE") rounds. Each of these categories of ammunition is manufactured in both training rounds, for practice, and advanced tactical or combat rounds. Thus, a total of four types of rounds constitute the current 120mm ammunition family: the KE advanced tactical (M829A2) and training (M865) rounds, and the CE advanced tactical (M830A) and training (M831) rounds.

 Alliant and Olin are the exclusive systems contractors for all rounds of 120mm ammunition. The two are responsible for roughly equivalent proportions of the total Army procurement, and together, they enjoy a monopoly over the development, manufacture, and sale of 120mm rounds. Alliant and Olin each produce both CE and KE training rounds, and both companies produced the previous generation of KE and CE tactical rounds. *fn1"

 The Army, however, contracted with only one company ("sole sourced") for each type of the advanced tactical rounds. Thus, Alliant is the exclusive systems contractor for advanced CE rounds, and Olin is the exclusive systems contractor for advanced KE rounds. Olin played no role in the development of the advanced CE round, although it produced the previous CE tactical rounds and produces CE training rounds. Transcript of Preliminary Injunction Hearing, November 16, 1992 ("P.I. Tr.") at 26. Alliant participated in developing the advanced KE round until Olin obtained the sole source contract in 1991. P.I. Tr. at 24. Both of these advanced tactical rounds presently are in low-rate initial production.

 The advanced tactical rounds feature critical technological advances over the previous generation. The main difference in Olin's advanced KE tactical round is a "sabot," produced at Olin's Flinchbaugh facility. The primary technological developments in Alliant's advanced CE tactical round are a fuse, produced under subcontract by Bulova Technologies, Inc. ("Bulova"), and a semi-smart sensor, produced under subcontract by the Motorola Corporation ("Motorola"). In addition, the advanced CE rounds are loaded, assembled, and packaged by Mason & Hanger-Silas Mason Co., Inc. ("Mason & Hanger"). P.I. Tr. at 24-28.

 Due to shrinking military budgets *fn2" and a projected decline in demand in the post-Cold War era, the Army determined in 1991 that it could no longer support two systems prime contractors for production of 120mm ammunition. Consolidation would reduce duplication of costly production overheads. The Army accordingly decided to reduce the number of systems prime contractors to one by 1994.

 The Army has several possible routes for designating a single producer for 120mm rounds. First, the Army could "breakout" the production from the systems contractors and oversee subcontractors' production of the 120mm rounds itself. The Army has overseen production directly in this manner for other defense products, such as the M910A5 ammunition round. P.I. Tr. at 30. This option would require hiring as many as 300 additional Army personnel to manage the subcontractors, however. Def. Ex. 53 P 13. Thus, though theoretically feasible, under the present growing constraints on the military budget, Colonel Franklin Y. Hartline has testified that a breakout would be "risky" and "difficult." P.I. Tr. at 30.

 In its Acquisition Strategy Report, finalized October 1992, the Army predicted that "the quality, reliability, performance and timely delivery of this 120mm tank ammunition could be severely jeopardized" under a breakout, and that "in-house resources are not sufficient/available to support the additional testing, quality assurance or procurement requirements" that would be required. Pl. Ex. 31 at 12. Alliant has assessed the probability of a future breakout at zero percent. Pl. Ex. 126.

 As an alternative to a breakout, the Army could downselect to a single 120mm supplier through a winner-take-all bid. The Army originally intended to hold a competitive bid for the 1994-1998 contract for training rounds. Following this downselect, the Army no longer would hold competitive bids for 120mm ammunition, but would sole source the munitions from a single supplier. The winner of the 1994 training bid thus would receive the sole training ammunition contract for the five year period, as well as become the sole systems contractor for the development, production, and sale to the Army of all 120mm rounds, both tactical and training, for the life of the program. As the sole United States producer, the winner also would gain a strong position (shared by the Germans) in an increasingly important foreign market.

 After the Army announced its intention to sole source 120mm ammunition, Alliant and Olin entered discussions regarding a merger of their 120mm operations. In the proposed agreement entered on August 4, 1992, Olin agreed to exchange its Physics International subsidiary and its Ordnance Division for approximately 2.82 million shares of newly issued Alliant common stock (valued at $ 62.39 million) and the assumption by Alliant of approximately $ 65 million of Olin debt. Following the issuance of the common stock, Olin will hold about 22 percent of Alliant's outstanding stock.

 Should the parties enter the merger, they would preclude the Army from conducting a competitive bid for the 1994 training contract. Alliant, together with the merged Olin divisions, instead would enjoy monopoly leverage in negotiating a sole source contract for that product, as well as acquire a monopoly over all other 120mm rounds.

 Both the merger and the competitive bid options for downselecting to a sole supplier bring unique benefits and costs. Louis A. Guth, an economic consultant and witness for defendants, argues the merger will save the Army $ 10 million in duplicate overhead costs, since the Army would not have to maintain two systems contractors in fiscal 1993. Def. Ex. 1 at 24(a). However, Jimmy C. Morgan, an Army procurement officer and witness for defendants, estimates that maintaining dual source overheads in fiscal 1993 would cost approximately $ 3 to $ 4 million. Pl. Ex. 212 at 118. Defendants also argue that intangible benefits in quality and efficiency would accrue from a merger of the best elements of both company's personnel and facilities.

 The merger option also has its costs. Neither party disputes that a competitive bid would result in lower prices for the 1994 training ammunition contract than the letting of the contract to the single source the merger would create. Because sole source contractors lack competitors, and because their profits are based on a percentage of costs, they have few incentives to lower costs. Pl. Ex. 203 at 7. There is persuasive opinion in the record that Army oversight, while effective, is an imperfect substitute for the action of the competitive market. Pl. Ex. 211 P 18; Pl. Ex. 205 P 34; Pl. Ex. 204 P 6; Pl. Ex. 6 P 9; Furthermore, as indicated above, the prospect of an Army breakout is too remote to discipline the merged entity's price demand.

 On the other hand, a competitive bid in the present context could result in unusually large cost savings, since the parties would be bidding not only for a five year contract, but for a future monopoly in all four 120mm rounds and a strong position in foreign markets. William Rogerson, Professor of Economics at Northwestern University, has declared that even a below cost bid might be a rational investment choice in order to ensure obtaining the sole source systems contract. Pl. Ex. 201 PP 5, 13. But compare Def. Ex. 20.

 Accepting that a competitive bid would result in a lower price for the 1994-98 contract, the only dispute here is the relative size of the discount a competitive bid would produce over a merger, and whether that competitive benefit would be offset by other hidden costs. Plaintiff estimates the contract price produced by a competitive bid might be as much as 23 percent less than the price without competition, a difference in cost to the Army between 42.7 and $ 115 million. Pl. Ex. 201 P 12; Pl. Ex. 1; Pl. Ex. 213. Plaintiff also notes that Olin requested a premium in exchange for entering the merger. Guth, on the other hand, estimates that competition would lower the contract price by "no more than five to ten percent," Def. Ex. 1 at P 22, or $ 25 to $ 50 million. Morgan has declared the Army expects Alliant's prices to rise three to ten percent after a merger, and is willing to pay up to 12 percent without reservation. Pl. Ex. 4 at 18.

 On the other hand, a competitive bid would impose other efficiency costs and possible risks. Estimated duplicate overhead costs for fiscal 1993 are discussed above. Most other costs are attributable to the fact that neither Alliant nor Olin now produces the advanced tactical round made by the other. To hold a competitive bid, therefore, the Army would have to make each company knowledgeable enough to bid intelligently for the other's advanced tactical round. Defendants estimate this cost at $ 4 to $ 6 million, with a possible production delay of 12 to 14 months. Def. Ex. 57; Def. Ex. 5 P 12. Morgan also expressed concern that participants in a competitive bid might stint on service quality in order to cut cost and win the contract. Def. Ex. 9 P 25.

 Other intangible difficulties might arise from the transfer of technology, adding further costs and delays. For example, Steven K. Conver, the Assistant Secretary of the Army for Research, Development and Acquisition, speaking on behalf of the Department of Defense ("DoD") and the Army, has declared that in the absence of the merger, a winner-take-all competition could leave the victor in a weakened position to execute the contract, that the losing company's technical and manufacturing capabilities could be lost, and that the surviving company might not be able to build the products to the Army's requisite quality, time schedule, and cost specifications. Def. Ex. 7; see also Def. Ex. 53 P 14(c).

 The cost of a technology transfer would be highest if Olin won the bid, since Olin has no experience with the advanced CE round, and because the advanced CE round uses semi-smart technology. Def. Ex. 53 at 10. Edwin H. Schmidt, Group Vice President of defense systems for Alliant, estimates that the transfer of technology to Olin would exceed $ 3 million, and that in a competition, Olin would add an additional $ 20 million to its bid to protect itself from the potential costs of the transfer. Def. Ex. 5 P 19-20. Alliant, on the other hand, was involved in the development of Olin's advanced round as recently as 1991, so that the technology transfer cost would be less if Alliant prevailed in the bidding.

 In assessing the hidden costs involved in the transfer of advanced round technology to Olin or Alliant, however, Joseph De Lorenzo, Chief of the Heavy Armament Division of the United States Army's Armament Research, Development and Engineering Center at the Picatinny Arsenal, declared that as long as the subcontractor base continues to be available to both systems contractors, Olin could become the systems contractor for the advanced CE round in 6 to 9 months, at a cost of less than $ 1 million. Alliant could become the systems contractor for the advanced KE round "almost immediately," at no additional cost to the Army. Pl. Ex. 206 PP 12, 13. De Lorenzo currently heads the group within the Army responsible for providing technical guidance on all 120mm tank ammunition to Colonel Hartline and others.

 Finally, defendants suggest an ultimate possible risk-- "that the Army's tankers will not have the ammunition they need if and when they are next called into battle." Alliant Mem. at 29; Olin Mem. at 20. At the preliminary injunction hearing, Colonel Hartline expressed concern that transferring advanced round technology to the sole surviving contractor would involve some cost, time delays, and program risk, ...


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